As we continue to evaluate real estate tax strategies stemming from the Tax Cuts and Jobs Act, CARES Act and current economic conditions, it is important for real estate entities and investors to take a second look at the provision on business interest expense limitations, under Internal Revenue Code (IRC) Section 163(j).
The good news on this front for the industry is that business interest expense continues to be deductible. However, for tax years beginning after 2017, limitations apply on the amount of interest you can deduct to calculate taxable income.
How the CARES Act Changed the Business Interest Expense Limitation
The annual limit was previously calculated to the sum of:
- 30% of the taxpayers adjusted taxable income (ATI),
- Its business interest income, and
- Floor plan financing interest.
The CARES Act enacted in March 2020:
- Increases the 30% of ATI to 50% for 2019 and 2020 for all entities except partnerships,
- Increases partnerships from 30% of ATI to 50% beginning with the 2020 tax year;
- Allows a partnership to treat 50% of its 2019 carryover interest as business interest that is not subject to the 163(j) limitation but is deductible on the 2020 return; and
- States that all subjected entities, including partnerships, may choose to use ATI from 2019 or 2020 to calculate the interest deduction limits.
These changes under the CARES Act will help companies deduct more interest expense, decreasing their tax liability during the pandemic.
Are Small Business Taxpayers Exempt from the Business Interest Expense Limitation?
Small business taxpayers are in fact exempt from the limitations under IRC 163(j). To qualify as a small business, you must have average annual gross receipts of $26 million or less for the three preceding tax years. Partnerships, though, should take caution when applying the gross receipts test because the limitation is subject to the aggregation rules under IRC 448(c).
A major exception for the small business qualification is the syndicate designated entity. A syndicate is a partnership, S Corporation or other noncorporate entity that allocates more than 35% of its losses during the tax year to limited partners or limited entrepreneurs. In prior years, many real estate partnerships may have been generating income, had met the small business exemption and had not fallen subject to the syndication rules. With the current pandemic dramatically changing the economics of the real estate market, today partnerships generating a loss could potentially be subject to the business interest expense deduction limitation because they now fall under the syndication rules.
Does it Make Sense to Take the Real Property Trade or Business Election?
There is a way for partnerships to opt out of the limitation, permanently, if you are a certain type of trade or business. These include any:
- The trade or business of performing services as an employee;
- Electing real property trade or business;
- Electing farming business; or
- Governmentally regulated electrical, water, sewage, gas, or steam sale or distribution business.
A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. If you are considering taking the election to be treated as a real property trade or business, you should review the regulations under 1.163(j)-9 carefully to ensure you meet all the requirements.
Also note that making the real property trade or business election is not without consequences. It requires your entity to use a longer deprecation period under the Alternative Depreciation System (ADS) for your newly acquired and existing depreciable property. And for newly acquired property, if it’s depreciated under the ADS system, it cannot qualify for bonus depreciation.
The situation related to Qualified Improvement Property (QIP) is not as straightforward and has changed since the TCJA was enacted. In that Act, Congress inadvertently omitted QIP under the definition of property that qualified for bonus depreciation. The CARES Act rectified this, allowing entities to immediately expense QIP under the bonus deprecation rules. This change may have a significant impact on whether or not your entity will make the election of a real trade or business in lieu of the bonus deprecation. Recognizing the potential opportunity this change could present for those already taking the election, the IRS issued Revenue Procedure 2020-22, which allows taxpayers to revoke the election retroactively if they choose. You can make the revocation by filing amended returns for any taxable year beginning after December 31, 2017, without any consent from the IRS.
As you work through tax strategies with your advisors over the coming months, discuss the recent tax law changes and how decisions related to the business interest expense limitation could significantly impact your tax positions now and for years to come.
Contact Ryan Broze at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.